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Making An Investment Plan
Making An Investment Plan
Before beginning on any long journey, it is important to make a good plan to maximize the
chances of success. It is the same with investing – it is prudent to make an appropriate
investment plan so that it can guide the investor though the investing journey. This article
attempts to address the basic steps to making an investment plan and constructing an
appropriate asset allocation.
Note: Before thinking about investing, the investor-to-be should consider making sure that
the basic financial foundation is already in place. This means that there should already be
some sort of emergency fund reserves allocated against a rainy day and the appropriate
family members are properly and adequately insured.
Knowing the investment goal is important because it ultimately determines the time
horizon of the investments before they are liquidated and consumed. The time horizon
factor, together with the need, ability and willingness to take risk will primarily determine
the appropriate asset allocation.
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much more able to handle risk than another investor whose income is dependent on the
economic cycle and the investment proceeds are needed in a few years.
2. Asset allocation
2.1. Fixed income to equity ratio
After reviewing the various risk factors, it is time to make the most important decision in
an investment plan, which is to decide on the fraction of money to invest in fixed income
versus equity instruments. Fixed income instruments refer to bonds, bond funds and money
market funds. These tend to have small day-to-day price fluctuations and they generally
provide stability in a portfolio. On the other hand, equity instruments refer to stocks
(including stock ETFs) and stock funds. Equity instruments provide opportunity for much
higher gains but these come at the expense of higher day-to-day price fluctuations and are
more affected by the economic cycle. Equity instruments generally are the engines that
provide the most “growth” in a portfolio.
Some of the suggestions to determine the fixed income to equity ratio are given below:
Age-based rule-of-thumb
This simple rule, which applies only to investments intended for retirement, suggests that
the percentage allocation to fixed income should be given by the investor’s age. For
example, an investor age 30 should allocate 30% to fixed income. Many have criticized
this rule of thumb as too general and that it assumes a “one size fits all” solution is
appropriate. This is probably true. Plus, in addition, it does not take the “need-ability-
willingness” factors listed above into consideration.
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Fixed income/ Average Best year Worst year Years with loss
Equity annual return return return
100/0 7.2% 31.1% -8.1% 5 of 45
80/20 8.1% 28.6% -8.2% 5 of 45
70/30 8.5% 27.4% -8.4% 5 of 45
60/40 8.9% 26.1% -11.3% 6 of 45
50/50 9.2% 27.9% -14.1% 8 of 45
40/60 9.5% 29.6% -17.0% 11 of 45
30/70 9.8% 31.3% -19.8% 12 of 45
20/80 10.1% 33.2% -22.7% 12 of 45
0/100 10.6% 38.5% -28.4% 12 of 45
http://flagship4.vanguard.com/VGApp/hnw/content/PlanEdu/General/PEdGPCreateTheRi
ghtMixContent.jsp
Using the above information and together with the “need-ability-willingness” factors, an
investor should decide on an appropriate fixed income to equity ratio that is tailored to the
investor’s personal circumstances.
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a) A young investor in early 20s just starting work and investing for retirement: 15/85.
b) A young couple in the early 30s with a young family and investing for retirement:
30/70.
c) A middle-age couple in the late 40s investing for retirement: 40/60.
d) A couple in the 50s, planning to retire in a few years: 60/40.
e) A retired couple in the late 60s, and drawing on assets for retirement needs without
children’s assistance: 80/20.
a) Author William Bernstein in his book “The Intelligent Asset Allocator” found that
historically, the volatility of a portfolio is significantly dampened by the inclusion
of just a small amount of fixed income (e.g. 10%) and yet the impact to the
expected returns is very minimal. In other words, the risk-adjusted returns of a
portfolio with say 10% in fixed income could be higher than a 100% equity
portfolio.
c) The addition of fixed income instruments gives the investor something to rebalance
against in a severe equity bear market. Without a fixed income portion, meaningful
rebalancing cannot be done if all the equity funds are down by similar proportions.
If an investor, after reviewing the above three points still feels that a 100% equity portfolio
is appropriate, then he or she should go ahead with a 100% equity allocation since he or
she would already be mentally prepared and will hopefully be less likely to make the
wrong decisions in a severe equity bear market.
Many different unique “sub-asset classes” can be created by combining the above
divisions. For example, by combining US with small-cap and value, we will have the US
small-cap value asset class. Emerging markets junk bonds would be another example.
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Not all asset classes so created have easily available investment vehicles in Singapore.
Therefore, below, we tabulate only some of the most important asset classes available and
of interest to retail investors. They are listed in the order of increasing diversification as
perceived by the author.
Equity funds
a) Global equity fund
b) US fund and EAFE fund (EAFE consists of Europe and Asia-Pacific)
c) US fund, Europe fund, Asia-Pacific fund
d) US fund, Europe fund, Asia-Pacific fund, Emerging markets fund
e) US fund, Europe fund, Asia-Pacific fund, Emerging markets fund, Global small cap
fund
f) US fund, Europe fund, Asia-Pacific excl. Japan fund, Japan fund, Emerging
markets fund, Global small cap fund
When a portfolio is large or if the investor would like to hedge against certain economic
situations, the following tangible asset and sector funds could provide added
diversification. These are listed in the order of DECREASING diversification values as
perceived by the author.
Sector funds
a) Energy fund
b) Healthcare / biotech fund
c) Single country fund
d) Other narrowly-focused sector funds
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2.3. Asset class selection
After the review of the different asset classes available, the investor can select one row
from the “Equity funds” group and another row from the “Fixed income” group to form the
desired asset allocation plan. One or more funds from the “Tangible asset funds” and
“Sector funds” group could also be selected.
Example A
Investor A prefers simplicity and does not wish to keep track of too many funds. He selects
the following investments for his asset allocation.
Example B
Investor B works in the energy sector and is planning for retirement. She is concerned
about the rising healthcare cost / inflation and does not mind the added complexity
associated with holding more funds. One example portfolio for her could be
Equity: US fund, Europe fund, Asia-Pacific fund, Emerging markets fund, Gold and
precious metal fund and Healthcare fund.
Fixed income: Global bond fund, SGD denominated bond fund, Emerging markets bond
fund.
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stock market capitalization of the three regions currently. Alternatively, for simplicity
reasons, it is also not a bad idea to allocate equal weighting to the three regions.
As for sector funds, it is best to limit the total weighting to be no more than 10% of the
entire portfolio, as already mentioned above.
In the author’s opinion, if asked to pick a fund selection criterion and given just only one
choice, the author would say that the expense ratio of the fund would be the single most
important deciding factor in fund selection (although it is still a very poor indicator). This
agrees with the results of a study done by Financial Research Corporation in the article
“Warning: Fund stats offer little help” (link here:
http://www.marketwatch.com/news/print_story.asp?print=1&guid={81EB08DF-AA29-
491E-9C0C-9889A48CAE84}&siteid=mktw ):
Of all the predictors, the expense ratio was the most reliable
in predicting future performance as funds with lower
expenses delivered "above-average future performance
across nearly all time periods."
FRC calls a favorable expense ratio an "exceptional
predictor" for bonds, and a "good predictor" for stock funds.
Savvy investors know that fees are one of the biggest drags
on performance. Once again, here's the proof. If you want
predictable performance, pick low expense funds, and that's
usually no-load index funds.
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One of the suggested acid-test to know if the portfolio allocation is right for an investor is
to see if the investor becomes worried and sleepless at night in a severe bear market. If this
is the case, then the investor probably has an overly aggressive portfolio and the equity
portion should be decreased and fixed income portion increased to the point where the
sleepless nights disappears.
When in doubt, an investor could always start of with a less aggressive portfolio, putting
the remaining money originally intended for equity investments into a money market fund.
After some time as the investor becomes more confident and convinced in the original
asset allocation plan, the money in the money market fund could be re-deployed into
equity instruments.
Rebalancing
It is important to periodically rebalance the portfolio. Since the performances of different
asset classes could vary by quite a bit from each other, over time, the relatively allocation
of each asset class would drift away from each other, making the portfolio out of balance.
Rebalancing means to re-allocate the money in the portfolio back to the original asset
allocation. This typically involves selling the winners and buying the laggards.
The rebalancing step is important as it enforces a discipline for an investor to take some
money out of the winning fund and buy the laggards at a relatively lower price. But more
importantly, it re-aligns the portfolio back to the same level of risk and return profile when
the portfolio was first set up.
When to re-balance?
Many investors like to do rebalancing once a year and a few have been known to do it near
their birthdays. Others prefer to do it around the time they receive their yearly bonuses,
when they have additional money to invest. The author thinks that this is quite a good idea
since the investor might then find it unnecessary to sell the winners (thus minimizing
transaction costs). Instead, with the additional funds available for investment, the investor
only needs to top up the laggard funds to bring the portfolio back into balance.
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Larry Swedroe’s 5/25 rebalancing rule
Author Larry Swedroe suggests using a 5/25 rule to rebalance, instead of relying on
specific time intervals. What this rule says is that the portfolio should be rebalance if at
least one of the asset class is 5% out of balance with respect to the entire portfolio or 25%
or more out of balance relative to its original allocation. An example will illustrate this.
Consider an asset class with a 10% allocation in an investor’s portfolio. Then the 5% “sub-
rule” says that if this asset class becomes less than 10%-5%=5% or more than 15%, then it
should be rebalanced. On the other hand, the 25% “sub-rule” says that if this asset class
grows to be more than 1.25*10% = 12.5% or less than 0.75*10% = 7.5%, rebalancing
should be performed. Combining the two “sub-rules”, the rebalancing points are triggered
at below 7.5% or more than 12.5%.
In the author’s opinion, the exact rebalancing method probably does not a lot of difference
since there is little evidence to suggest that one technique is better than the other. What is
more important though is that rebalancing is performed diligently with a predetermined
method.
4. Conclusions
We have reviewed the major steps in making an investment plan. This consists of four
main ingredients – 1) review of the investor’s risk profile, 2) selection of the appropriate
fixed income/equity ratio, 3) refinement and selection of fund vehicles for each asset class
and finally 4) implementation of the plan, investing regularly and rebalancing diligently.
About the author: Indexfundfan works in the semiconductor industry and currently resides
in Silicon Valley in California, USA. He has been investing since 2000 and likes to read
investment articles in his free time. He can be reached at indexfundfan AT gmail DOT
com.
Disclaimer 1: The above article attempts to summarize the important steps and
considerations to making an appropriate investment plan, to the best of the author’s
knowledge. The author provided the above information in good faith and with neither any
guarantees nor remuneration. Before investing, remember, it is your money and it is you
alone who will have to bear the consequences of bad investment decisions. The author
cannot be held responsible for any bad investment outcomes.
Disclaimer 2: The content of this article should not be construed as an offer or solicitation
for the subscription, purchase or sale of any fund. No action should be taken without first
viewing a fund's prospectus. Any advice herein is made on a general basis and does not
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take into account the specific investment objectives of the specific person or group of
persons. Performance and any forecast is not necessarily indicative of the future or likely
performance of the fund. The value of units and the income from them may fall as well as
rise. Opinions expressed herein are subject to change without notice. The information
provided by this article is provided "AS IS" and is provided by way of a simple summary.
The author does not warrant the accuracy or completeness of the information, text,
graphics, links or other items contained in this article, and the author expressly disclaims
liability for errors or omissions in these materials. The author makes no commitment to
update the information contained in this article. Accordingly, you are advised to read the
relevant prospectuses for further information and to consult a MAS licensed financial
representative.
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